The hot topic of taxation

appeared in the JEP Funds Review, May 2013

Valarie Johnston, a manager on secondment to PwC CI from PwC US, explores some of the less well-known pitfalls when it comes to US tax reporting

As the world shrinks with the rapid evolution of the global economy, the risks continue to grow. In the fund industry, both locally and globally, the exposure to U.S. tax reporting requirements and the associated risks continue to be “hot topics”. As U.S. tax regulators in varying jurisdictions utilise resources to augment their detective skills, they are also making it “worthwhile” to know your exposure. As funds and administrators look for ways to mitigate global risk, the following considerations should be highlighted. If ever there was incentive, it’s now.

Historically, Internal Revenue Service (IRS) audits focused on multinational and other large corporations. However, business, and therefore audit focus, is evolving.

IRS figures indicate approximately 70% of filers with assets of $10 million or greater are flow-through entities, and this number is expected to continue to grow. To correspond to this material move toward flow-through structures, and clearly bringing focus on the fund industry, IRS Agents are now receiving specialty training in areas including pass-through structures, financial products (e.g., derivatives, swaps, etc.), international issues and reporting, and audit techniques utilizing technology.

To further enhance the IRS audit process, technology is clearly being leveraged as well. Historically entities were generally selected for audit based on their filings, but trends show that business relationships, including investments and investors, are being reviewed and may impact exposure to audit selection. For example, one IRS initiative focuses on high net worth individuals. In such cases, the IRS audit the complete portfolio of the individual, which includes inquiries of investments held.

While funds generally have an awareness of Federal U.S. tax reporting risk, State and Local government tax reporting have often been overlooked or deemed immaterial. As technology allows governments to do more with less, these lower levels of government are getting smarter. Developments include everything from new reporting requirements and associated taxes, to new ways to collect tax and find tax evaders.

All 50 of the U.S. States maintain their own tax code, while many local governments do as well. With technology advancements allowing for improved monitoring, these tax codes are becoming more detailed and directed. For example, California recently revised state tax code to require any entity receiving income of >$500k USD from California residents to file with the State. In this scenario, a California filing requirement could exist although a Federal filing may not.

While tax codes evolve, penalties seem to multiply as well. As the risk profile of a fund is considered by management, high penalty factors often mean compliance with state filing requirements far outweigh the risk of penalty if caught non-compliant. One such factor which states are using is the assessment of penalties based on the number of partners in a fund, such as New York. On the other hand, states like Massachusetts assess a daily penalty with no time or monetary limit.

Although tax codes are enhanced and penalties are severe, the third act to the show is the ability to find and collect. Improved technology is enabling tax authorities to “connect the dots” between investments and investors and in effect send notices in instances where, for example, an investment files with a state but the investor does not.

While risk and penalties are a concern when considering U.S. tax compliance, returns to investors are equally if not more important.

As the focus on the identification and reporting of “ECI” and “FDAP” continues to rise, the related withholding is often not completed correctly. For example, the withholding Forms 1042-s and 8805 may seem similar but key differences exist between the forms that lead to confusion varying from who should be the recipient to amounts reported.

Additionally, withholding entities have often received incorrect, outdated information and have made determinations that may not be correct. Unfortunately, this often results in a flat rate of 30% being withheld instead of a blended rate of much less. The investor must then choose between filing with the U.S. to receive a refund, or forego the difference that should have been in their pocket to start.

As investors become more versed in regulations and reporting, withholding is becoming a significant focus. However, with FATCA looming and requiring enhanced documentation about investors, the information should become more accurate and readily available. Additionally, with technology improvements easing the tracking of complex reporting structures, it seems the historically high barriers should be minimized. As funds look for ways to continually increase returns to investors, improvements to withholding may be “low hanging fruit” when it comes to compliance with new regulatory requirements.

As reporting requirements evolve, technology is enhanced, and the global economy continues to develop, the mitigation of risks from investor relationships and reputations to monetary amounts will continue to be a key driver of success. Although risk profiles may differ from fund to fund, an important step to navigating the grey is to be aware of exposure by understanding the risks and having processes in place to monitor them.